Swaps: Is The Wall Street Gold Mine On Its Way Out?

Is the current move by Pennsylvania lawmakers to ban state and local governments from using interest rate swaps a sign of things to come for private, not-for-profit hospitals? Not likely, but for many CFOs and their boards, swaps have become a dirty word.

This wasn´t supposed to happen. In the beginning, "plain vanilla" swaps helped hospitals achieve a lower "synthetic" fixed rate than traditional fixed rate bonds. The math was compelling, and LOC banks were eager to back variable rate debt. Soon, complex structures emerged, limited only by the imagination of swap desks, some quite challenging to assess from a risk standpoint. Bankers were paid upfront for profits that often reached into the millions of dollars over the life of a long-dated swap. A large percentage of underwritings came to involve swaps, and swaps eventually represented about two-thirds of Wall Street´s public finance profits, dwarfing underwriting revenues.

While banks offloaded risk by hedging their swap portfolios, hospitals had to book at least a portion of negative mark-to-market swings as unrealized losses. Boards grumbled at the magnitude of the dollars involved, but everybody knew the losses were non-cash. That is, until the auction rate market collapsed in 2008, accompanied by massive wave of LOC bank downgrades and failed remarketings. Borrowers scrambled to refinance put debt with fixed rate debt and terminate swaps that were no longer needed, but negative mark-to-market values made some terminations very painful. Those who stayed with variable rate debt received an unpleasant education in basis risk when the percentage of Libor payments from swaps became substantially less than the SIFMA coupon owed to bondholders.

Looking back, would any CFO want to enter into a pay-fixed swap with the knowledge that rates are going to go lower, not higher? 20/20 hindsight is a wonderful thing indeed. Right now, regulators do not seem to care that many swaps were designed to hedge against higher rates, and that for the most part, they worked exactly as promised. Swaps will continue to be a valuable tool to optimize a hospital´s debt structure, so long as borrowers take time to identify and assess all risks involved.